Monday, February 16, 2009

The Harry Markowitz Approach

One outcome many of us (practitioners) walk away with from the financial mess we helped create is that, perhaps, simplicity is king.

Yes, cash is king for you and your fund and its survival. But when the world is out of control, unless you're John Paulson, you're probably going to suffer by way of your retirement investments, personal investments, or hedge fund investments (for the high-net-worth individuals out there).

One way or another, we almost all suffer from a credit freeze. We all suffer from complexity.

Modeling complexity, itself, leads to an additional premium be charged on the product (you would want more "spread" for owning it due to the difficulty analyzing it). Additionally, the more complex the financial instrument, the more prone it is to different "risks" and typically the more illiquid the instrument -- and, hence, an additional "illiquidity premium" that decreases the value of the asset.

On the structured finance side, the different risks mentioned above may include default and default timing risks, prepayment speed "risk," recovery rate risk, interest rate risk, extension risk, covenant risks &c.

Now these are not all bad, always. As we know, with risk comes return and, for example, prepayment speeds may work in your favor as a certain tranche holder in the structure, and in another holder's disfavor. But this is fixed income, primarily -- typically less than 10% of each structure is equity-like -- and so you know your upside: par. Risks that may affect your note's ability to get said "par" are suboptimal. And it's not a zero sum game: when the deal performs poorly, almost everyone suffers.

Back now to simplicity. The easier it is to understand and model the variables that may affect your note's future cashflows, the easier it is to predict future income to your note; the easier it is to "value" the note ... to sell the note, &c.

And we think Harry Markowitz "gets it." Indeed we may bedgrudge him some or many aspects of his "modern" portfolio theory. (We have, for example, expressed our skepticism that the "diversification" offered by multi-strategy hedge funds actually mitigates against the sharper downs, no pun intended, in "Jack of All Trades?")

But his piece "Proposals Concerning the Current Financial Crisis" for the Financial Analysts Journal is simple and to the point: we need transparency. His approach to obtaining the necessary data is perhaps optimistic and debatable, but the message is clear. Information, no clarity, no simplicity is king.

The key takeaway: the more we know about what the assets are, and who holds them, the better able we will be to allocate sufficient funds to buffer against the pending problems, and to choose how and where best to apply such funds.

1 comment:

DonAngelo said...

it's the KISS principle. Too many variables for anybody to accurately measure. it's amazing to me that pension funds (aside from the big ones) were even allowed to invest in cdo-squareds and these DPC structures. now we all suffer by way of state taxes